Don’t sell income funds, nor accrual funds

Provocative title – but certainly a point for us in the industry to ponder about. Just who is benefiting by us selling accrual and duration based debt funds to investors, instead of simple liquid funds – even for 3, 5 and 10 year horizons? Are investor returns from income funds commensurately higher than liquid funds, given the incremental volatility and risks involved? If the answer is negative, why is this so? Is it because longer duration securities do not yield more than overnight money, or is it because most of the incremental returns are being consumed within the industry without being passed on to the investor?

I met a CEO of a large AMC the other day at an airport and during the course of our conversation, he pointed out to me how we as an industry are perhaps failing the fixed income investor. He talked about how long term returns across all product categories of fixed income funds are converging around returns of liquid funds and that one of the biggest factors for this was that almost all the incremental return was being taken away by the industry by way of higher expense ratios.

We did a quick fact check on what he mentioned, and here is what the numbers reveal:

This table compares category average returns across the 5 fixed income categories in the ACE MF database. Medium term income funds category is where most of our retail favourite accrual funds would be. Since we sell income funds for a 3 year + horizon, lets focus on 3, 5 and 10 year returns. The incremental return over liquid funds is broadly in the 30 bps to 60 bps range over all these 3 time horizons, across short and medium term funds. Not a very encouraging outperformance, given the extent of incremental skill and resources expended in taking credit decisions, duration calls and so on. And given the gyrations of the fixed income market, I doubt whether risk adjusted returns will actually stack up favourably for any category vis-à-vis liquid funds. Long term income funds have actually underperformed liquid funds over all 3 time periods!

As can be seen clearly from the table, the culprit is not the structure of the yield curve, but the structure of expense ratios in the industry. We believe liquid funds are simple and need less fund management input, and therefore charge only 20 bps as average expense ratio. We however believe that other fixed income fund categories require a lot more skill and effort – in managing and selling – and therefore charge a much higher expense ratio. Now, if the returns to the investor are not commensurately higher, what then is the point of this incremental effort? Are we better off selling them only liquid funds for all time horizons? Or is it really time for the industry to take a long hard look at expense ratios in fixed income funds and adjust them downwards to actually deliver value to investors?

Look at it another way: incremental 3 and 5 year returns of medium term funds over liquid funds is 40 – 60 bps. Lets average it out to 50 bps. That’s what goes to the investor. But the incremental expense ratio is 140 bps – which, if you split down the middle, means 70 bps each for the fund house and the distributor. So, out of the 190 bps of incremental returns that the category generates, only 50 bps goes to the investor, with the distributor and the fund house making more money for themselves on incremental returns than the investor, whose money it finally is!

Now before you jump at me for suggesting that we are perhaps not acting in the investor’s best interest, and before you show me how averages are misleading and how individual funds that you sell (or manage) are doing vastly better than category averages, let me put that objection on the table myself. Here is data that compares the best performer in each category for each time horizon. Mind you, within each category, different funds come out on top on 3 yr, 5 yr and 10 yr horizons – making the task of picking the right winners all the more challenging.

Outperformance of the best in category of each category over the best in category of liquid funds ranges from 100 bps to 200 bps, with one outlier at over 250 bps. That’s far more comforting a gap compared to 30 bps to 60 bps. But before we take comfort in these numbers, let’s ask ourselves two questions:

• For distributors and advisors: how confident are you of picking the winner for each time horizon for each category, which you believe will generate that incremental 100 bps – 200 bps return?
• For fund houses: how confident are you, when charging your expense ratios on a daily basis, that your funds will come out on top of performance league tables across all time horizons, thus generating that incremental 100 bps – 200 bps of returns, even after charging over 100-140 bps more in your expense ratios?

My humble submission is that if neither of the two stakeholders can stake such a claim with sufficient confidence, maybe its time to sit together and agree haircuts across management fee and distribution fee, which can deliver a sustainable incremental return to the investor which she deserves. Or is the investor better off simply investing in liquid funds for time horizons of 10 days to 10 years?

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